In a better world, the daily fraud perpetuated at a strip club wouldn’t go beyond silicone implants and claims of paying law school tuition. But alas, these are dark times we find ourselves in.

Squarely within the seamy underbelly of Jackson, Michigan stood Potter’s Pub, a “gentlemen’s club.” Potter’s derived its business entirely from cash transactions – food and drink purchases, cover charges, juke box and pool table receipts, and moneys paid to the pub by its stable of dancers for the privilege of grinding out three-minute sets to “Pour Some Sugar On Me” on company-owned poles.

And business was good. So good, in fact, that the sole owner and president of Potter’s was thinking of selling out and moving on. Unfortunately, his first set of prospective buyers also happened to be IRS special agents who had caught wind of some doings’ a-transpirin’ at Potter’s, and set up an undercover sting to get a closer look. Here is an artist’s rendition of the high-tech surveillance equipment employed by the IRS* in its operation:

While meeting with the undercover agents, the president of Potter’s explained that the business was much more profitable that it appeared, and that he only deposited enough in the corporate bank account to cover expenses. The rest, he detailed, was sent to a personal bank account in Florida in denominations less than $10,000, done specifically to avoid required bank reporting that would alert the IRS. Just in case his verbal testimony failed to adequately sway his prospective buyers, the hopeful seller went on to produce a second set of books that reflected the true income of his enterprise.

Needless to say, things did not end well for the president of Potter’s Pub. The IRS searched the establishment, seizing the clandestine ledger as well as $200,000 in what I can only presume was crumpled up singles.

To his credit, after the search the president of Potter’s filed amended tax returns for 2003, 2004 and 2005. Unsympathetic to this conciliatory act, however, the IRS pursued prosecution, and in 2009 the taxpayer was charged – and pled guilty – to filing false tax returns. He was sentenced to 18 months in prison and ordered to pay restitution of $400,000.

Once free from prison, the proprietor of Potter’s Pub’s troubles were far from over. There was still the little matter of his tax liability for the tax years 2002-2005; specifically, the imposition of nearly $250,000 in fraud penalties under Section 6663. It was this fraud penalty that landed the taxpayer in front of the Tax Court.

Section 6663If any part of any underpayment of tax due on a return is due to fraud, Section 6663 imposes a penalty of 75% of the portion of the underpayment due to the fraud. The burden falls on the IRS to prove fraud, and this evidence must be clear and convincing. If the IRS can prove that any portion of a taxpayer’s underpayment was due to fraud, the burden then shifts to the taxpayer to prove that the entire underpayment was not attributable to the fraud. This much is well established. What is less clear in the tax law, however, is the answer to the question, what constitutes fraud?

The courts have defined fraud as the “intentional wrongdoing designed to evade tax believed to be owing.” That’s lovely, but not particularly helpful. Fortunately, in Spies v. U.S., 317 U.S. 492 (1943), the Supreme Court established eleven “badges of fraud” that indicate fraudulent intent:

Understating income;

Maintaining inadequate records;

Giving implausible or inconsistent explanations of behavior;

Concealing income or assets;

Failing to cooperate with tax authorities;

Engaging in illegal activities;

Providing incomplete or misleading information to one’s tax preparer;

Lack of credibility of the taxpayer’s testimony;

Filing false documents, including false income tax returns;

Failing to file tax returns; and

Dealing in cash.

After a thorough review, the Tax Court concluded that the badges of fraud overwhelmingly demonstrated that the taxpayer acted with fraudulent intent for each year at issue. The owner of Potter’s Pub substantially underreported both his corporate and personal income over a period of years (1), maintained two sets of books (2), concealed income by skimming from Potter’s Pub (4), hid his secret ledgers from his accountant (7), filed false tax returns (9), and as is a hallmark of the strip club industry, dealt only in cash (11).

In his defense, the taxpayer argued that he lacked fraudulent intent because he was, well…stupid, and didn’t know any better. The Tax Court disagreed, rightly citing the sophistication necessary to conceal more than $2 million in gross receipts and to evade bank reporting requirements while skimming cash.

And thus ends the Ballad of the President of Potter’s Pub.

Tony Nitti is a tax partner at WithumSmith+Brown in Aspen, CO. When he isn’t writing or teaching about tax policy, you can find him skiing, mountain biking, or driving around in a van with his dog, solving mysteries. Find Tony on Twitter at @NittiGrittyTax